Question

Jonhsons Company (JC) utilizes interest rate caps to control financing costs. It paid $100,000 to cap a 5-year $10 million loan at 5%. Prime rate was below 5% in year one. The rates were 6%, 8%, 5 %, and 7% the subsequent years the loan was outstanding respectively. What was the average level of annual finance costs associated with the loan?

Answer 1

The average level of annual finance costs for Johnsons Company's loan is $140,000, including the interest rate cap cost, and additional interest paid when rates exceeded the cap over the five-year period.

Step-by-step explanation:

The average level of annual finance costs associated with Johnsons Company's loan can be calculated by considering the interest paid each year beyond the cap rate due to the interest rate cap agreement, in addition to the upfront cost of the cap itself. Since the prime rate was below 5% in year one, no additional interest payment is made. However, for the subsequent years, payments are needed whenever the rate exceeds 5%, resulting in extra finance costs for years two, three, and five.

The interest rates for the five years are as follows:

• Year 1: Below 5% (no additional cost due to cap)
• Year 2: 6% (1% over cap: 1% of $10 million = $100,000)
• Year 3: 8% (3% over cap: 3% of $10 million = $300,000)
• Year 4: 5% (at cap rate, no additional cost)
• Year 5: 7% (2% over cap: 2% of $10 million = $200,000)

The total interest paid due to rates exceeding the cap is $600,000 ($100,000 + $300,000 + $200,000), and adding the initial cost of the cap ($100,000), we get $700,000 over five years. Therefore, the average annual finance cost is $700,000 / 5 = $140,000.